Dollar Bends, but Doesn't Break

The US dollar is broadly lower against nearly all the major and emerging market currencies. Its firmer tone against the yen is the main exception. Risk-on is the general theme de jour. Equity markets are mostly higher in Asia and Europe. Peripheral bond markets are also firmer, as the Spanish and Italian rally continues. Core bond yields are mostly higher. The advance in the foreign currencies has left them a bit over extended at the start of the North American session. Day traders have to decide whether its a trend day or a consolidative day. Given the choppiness of conditions and the lack of important fresh developments, we are more inclined to see the latter. Look for the dollar to stabilize and claw back some of its losses. However, as we noted in our weekly positioning and outlook report some adjustment in positioning is likely ahead of key events next month. The fact that US yields are a bit higher too seem incongruous with the hypothesis that the dollar's weakness is a function of anticipation that the FOMC minutes, due out later today, will provide more details into the possibility of QE3. While QE3 does remain a distinct possibility, we also recognize that the most recent string of economic data generally paints a picture of an economy stabilizing and even firming a bit from the soft patch with in the soft patch in H1. This too is part of the pattern of the last couple of years. However, we do take note of the San Francisco Fed report out yesterday that noted that the tight credit conditions was not a simply a function of weak demand from deleveraging households. The San Fran Fed also found banks less willing to lend if a household had defaulted or had low credit scores. While that prudence may be understandable, the report suggest that in addition to keep borrowing costs low, the Fed must find ways to induce banks to lend. This speaks to the possibility of a funding for lending scheme, similar but different that the one the UK is experimenting with. It seems to be the next step in the process. The first step was to arrest deflationary forces. Success. The second step was to lower interest rates. Success. The third step is to boost lending. Banks were largely on the sidelines through much of the Great Depression. The Federal Reserve moved into the vacuum and lent directly to businesses and households. While this does not seem likely, some kind of program to directly encourage lending is possible. While US deposits have risen 3.3% in the June-July period, for example, C&I loans have risen only 0.7%, according to Bloomberg data. The "to-ing and fro-ing" and the " he said, she said" push-me pull-you among European officials has continued. The market continues to suspect, with or without the Bundesbank's approval, the ECB is preparing to buy sovereign bonds if requested. The precise "modalities" as Draghi called them at the last ECB press conference are still be worked up. Even though the details are not available and won't be for a couple of weeks, we are skeptical on a number of counts. First, the substantial rally could very well be the "buy the rumor, sell the fact" type of activity, long familiar to investors. Second, any target in terms of quantity or spread will be easy targets for speculators. Third, even if such targets are not pre-announced, the market will fish for them and once discovered, exploit them. Fourth, the underlying problem, we argue and see some officials acknowledging, is the disruption of the private sector being able to recycle surpluses back to the deficit countries. Official sector purchases does not resolve this problem, but may in fact exacerbate it. Just like by convention, the market compares a sovereign, such as today's Spanish bill auction, to the most recent past auction instead of how the instrument is trading in the grey market, or in the secondary market, so too does the market think about yields as the nominal benchmark yield. However, the more telling yield is the effective yield on a country's debt, shown here. This has not deteriorated nearly as much as the benchmark yields would suggest.Three developments today seem particularly noteworthy. First, Ireland, arguably the best positioned of the countries receiving assistance reportedly will issue as much as 500 mln euros of amoratizing bonds (makes principal and interest payments every year) with maturities of 15-35 years. This type of product serves the needs of pension funds and insurance companies. It is another modest attempt by Ireland to re-enter the capital markets. Second, the UK CBI industrial trends were much weaker than expected (-21 vs -10 consensus), but this is hardly surprising. The economy remains in poor shape even if the Q2 contraction was not as deep as initially reported. The economy remains in its funk. Rather what caught out attention was the unexpected budget deficit. The details included a 0.8% decline in tax revenues, featuring a 19.3% decline in corporate tax revenue, which was partly a function of closing a North Sea oil producer, and a 5.1% rise in government spending. The rise in government spending belies the government's austerity. The social stabilizers mean that as the economy weakens in part under the cut in government spending and higher taxes, the counter-cyclical spending increases. Third, the minutes from the Reserve Bank of Australia meeting continued to downplay the need for additional easing and seemed to recognize that some of the demand for the Australian dollar is coming from reserve managers, e.g., the Swiss National Bank. This helped lift the Australian dollar back above the $1.05 area.